ICOs: Peril or Menace or Expression of Satoshi Spirit? (Chapter 5, Part 2)

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way…

– Charles Dickens, A Tale of Two Cities

Crypto advocates differ dramatically on the impact of Initial Coin Offerings (ICOs). They are a valuable dynamic that financed Ethereum’s smart contract; they are a blank cheque for scammers; they give government a wedge with which to separate cryptocurrency from freedom. The damnable thing is that all the assessments may be correct.

What does this have to do with privacy? In my opinion, current ICOs are regulation bait. The bad behavior of some ICOs and the recent hacks of others provide the perfect justification for governments to clamp down, not only on ICOs but, perhaps, on all cryptocurrency. Just as centralized exchanges are becoming quasi-banks, which are the “trusted third parties” Satoshi reviled the most, ICOs could come to resemble securities or private equities. In some places, that process is underway. The regulation gives government access to additional funds, of course, but it also provides detailed information on every investor. It nationalizes another bastion of free-market finance.

What is an ICO?

An ICO is a type of crowdfunding or crowdsale for startups, which allows them to generate capital while bypassing the restrictive requirements and costs of regulatory compliance and of dealing with intermediary financial organizations. A startup allocates a specified number of “tokens” to early investors in exchange for an established “money,” often bitcoin. The token is a pre-mined cryptocurrency that is issued by the startup. If the crowdfunder’s financial goal is not met, then the money is supposed to be returned to investors.

Some startups add incentives, which vary: dividends on future products, or services, for example. But the main incentive: if the financial goal of the crowdfunding is met, and when the ICO goes public, the token holders may see their investment soar in value. The tokens become a functioning currency, with a value linked to that of the startup. In 2014, for example, Ethereum’s ICO raised $18 million, which made each Ether coin worth approximately $0.40 US. Today (January 26, 2017), the price hovers around $1050.

The Disagreement

Some crypto advocates believe ICOs embody the original spirit of Bitcoin. Marcel Chuo of bitcoin.com wrote, “ICOs allow any investors around the world to have complete freedom to choose how to invest their money. By contrast, private equity is restricted to ‘accredited investors’ which is the result of a bunch of rich people pressuring the government to set up barriers to the common folk making money…” It is a fair and accurate point.

An accredited investor is a person who is rich enough to qualify for a government-granted privilege; he is allowed to invest in so-called high risk ventures, like startups, while the average person is prohibited. It is a financial privilege accorded to the upper echelon of wealth. Regulations vary from country to country, but the American ones are typical. The Securities and Exchange Commission (SEC) offers one of three ways to qualify. The individual (or entity) must have an annual income of $200,000 or a joint one of $300,000; he must have a net worth of over $1 million; or, he must be a general partner, executive officer, or somehow in business with whomever is issuing the security. Common people are deemed to be too stupid or unsophisticated to take such financial risks. They are generally restricted to investing in mutual funds and other low-risk, low-return vehicles.

Importantly, accredited investors must file a regulatory disclosure form with the SEC, which lays open their finances to government.

Cryptocurrencies and non-regulated ICOs blow past the legal privileges of the rich. They open a wide window for the average person to invest by the same rules as the rich, while skirting reporting requirements. Cryptocurrencies and non-regulated ICOs give average people the chance to profit hugely by taking a risk.

Of course, it is also possible to lose hugely. Under the best of circumstances, startups are high risk. The best of circumstances include – and, perhaps, rest upon – the honesty of those conducting the ICO. But even legitimate startups can go bankrupt, be hacked, be shut down by government, or collapse for another reason. Without honesty, however, the ICO is a scam.

ICO scams seem to have increased in recent years. Several factors are at work.

A feeding frenzy for crypto has descended on investors, and many of them do not act wisely because they fear missing the next, best thing. ICOs have also become a fad, akin to the dot.com fad in the late 1990s; the dot.com bubble collapsed circa 2001. Like many of their ill-fated predecessors, some ICO offerings now seem to rest on nothing but talk. Yet, they draw investors. An article in Quartz (July 07, 2017) reported, “A cryptotoken called ‘Useless Ethereum Token’ has raised over $40,000 in just under three days. Here’s its pitch: ‘UET is a standard ERC20 token, so you can hold it and transfer it. Other than that… nothing. Absolutely nothing’.” The useless, gag crypto reportedly raised 310.445 in Ether, $324,120 in US currency, and it issued 3,965,716.097 tokens. The investments occurred despite a header on the main website, which declared, “You’re going to give some random person on the internet money, and they’re going to take it and go buy stuff with it. Probably electronics, to be honest. Maybe even a big-screen television. Seriously, don’t buy these tokens.”

But there are blatantly dishonest ICOs. Crypto-veteran Kai Sedgwick recently wrote, “Benebit, one of this year’s most hyped ICOs, has pulled an exit scam, making off with a reported $2.7 million of investor funds. Other estimates put the figure as high as $4 million. The fraud only came to light after someone noticed that the team photos had been stolen from a school website. Once this happened, the Benebit team scampered…” Benebit had been endorsed by many respected ICO forums and sites, such as the clearinghouse ICO Syndicate. In short, due diligence would not have saved investors from losing their life savings.

And, then, there are the honest ICOs and exchanges that are simply incompetent. On January 26, 2018, a team from the Japanese Coincheck exchange held a press conference to discuss the theft of between $400 and $534 million; the vagueness comes from whether the stolen funds are assessed at the time of investment or their current value. A hacker cleaned out the exchange’s crypto in a single transaction because it seems to have been held in one hot wallet, which had no multi-sig. In short, the security resembled swiss cheese. Coincheck was one of the respected exchanges; ICOs are far more notorious for bugs and vulnerabilities.

Phoney or incompetent ICOs may seem humorous to non-investors, but there is sobering aspect that could easily affect them. Bad ICOs draw government regulation. In fairness, both ICO successes and scams are regulation bait.

An instance of attacking their success: In early September, 2017, China banned ICOs as being disruptive to financial stability. Translation: crypto and free-market ICOs were so popular that government could not control them. The ban appears to have been a means to clear the financial decks in order to allow only ICOs that function under government control to return. A headline (January 26, 2018) in The Bitcoiniststated, “Chinese Official: New Regulations for 2018 May End ICO Ban.”

If so, only “official” ICOs will be permitted, including ones conducted by government agencies.

Meanwhile, the SEC takes a different tack, which is no less damaging to financial freedom. It has started to classify some tokens as securities and to prosecute startups that issue them for violating federal security regulations. An article in CNBC (January 25, 2018), entitled “SEC devoting ‘significant’ portion of resources for catching cryptocurrency scams,” warned that the SEC “isn’t making much distinction between security and utility tokens, and that securities law applies to at least some cryptocurrencies.” Soon, SEC regulation may apply to all ICOs. Even if it does not, who would issue tokens with the risk of SEC persecution hanging over the process?

Complying with securities regulations is an onerous process. Of course, there are exceptions to when an investment is labelled a “security.” One is if only accredited investors are accepted. This returns the rich to a position of financial privilege, which may be part of the SEC’s goal.

ConclusionICOs started as innovative vehicles that allowed average people to invest in startups, and allowed startups to bootstrap themselves without government obstruction. There was always room for scamming, however. Many ICOs now defraud innocent people and give government a perfect excuse for regulation.

Government will only accept crypto and its related manifestations, such as ICOs, if it can be in control of them. Grabbing the wealth is certainly one goal but social control is another. The key to both is information. The looting of data is about to accelerate. Precaution should as well.

[To be continued next week.]

Reprints of this article should credit bitcoin.com and include a link back to the original links to all previous chapters

Wendy McElroy has agreed to ”live-publish” her new book The Satoshi Revolution exclusively with Bitcoin.com. Every Saturday you’ll find another installment in a series of posts planned to conclude after about 18 months. Altogether they’ll make up her new book ”The Satoshi Revolution”. Read it here first.